A 'January Effect' for Bond Fund Flows

Christine Benz: Hi, I'm Christine Benz for Morningstar. January was a great month in the equity market, but investors weren't buying stock funds. Joining me today to discuss the latest trends in mutual fund inflows and outflows is Kevin McDevitt. He is editorial director with Morningstar.

Kevin, thank you so much for being here.

Kevin McDevitt: Thanks for having me, Christine.

Benz: Kevin you mentioned in your report that January was sort of a "January effect month," but not for stocks. What were the big beneficiaries in terms of fund flows during the month?

McDevitt: It was really bond funds across the board, especially taxable bond funds had more than $24 billion in inflows last month, which was really one of the best months for taxable bond funds over the last three years. Certainly from the last 12 months that's one of the better showings.

And also you continue to see this resurgence, this revival of popularity with municipal bond funds. You had inflows there of more than $6 billion, which is the best showing for municipal bond funds since, I believe, about 2010. So ... you've seen a very strong revived interest in bond funds across the board.

Then secondarily, you also saw a return of flows to some balanced funds, world allocation funds, and conservative allocation funds, in particular.

Benz: So back to taxable bond funds, those were the biggest asset gatherers. If you drill in, which categories saw the most asset inflows during the month?

McDevitt: Intermediate-term bond funds were the big winners, which has been somewhat of a trend lately. The category had over $11 billion in inflows last month, and that continues, again, a trend of strong inflows into that category. That tends to be the core bond category for a lot of investors. So in some ways, it was not necessarily surprising that that category would lead the way.

You also saw very strong inflows into high-yield bond funds, too. You had over $6 billion go into that category. And that's been ... a more volatile category in terms of flows. You had tremendous outflows only about four or five months ago out of that category. But the last few months, you have seen stronger flows into high-yield bond funds.

Benz: I would like to get your take, Kevin, on what you think is driving these flows. It's obviously not yields, which have been shrinking ever lower seemingly month by month. What do you think investors are attracted to? Is it as simple as the fact that returns for bond funds were better than equity fund returns in 2011?

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McDevitt: I think that's certainly a big part of it. I think you have a lot of attractive factors--at least on the surface--working here in favor of bond funds.

Certainly, as you mentioned, strong returns last year and much better returns than you saw in the equity markets, makes it [attractive to investors]. I think, investors these days with a lot of risk aversion out there, they are more inclined to want to buy bond funds anyway, and seeing how much better they performed than equity funds last year makes that all that easier for investors to shift more money toward bonds.

So it's a factor of ... both returns, but also perceived safety, I think. And plus, you had the Fed announcement in late January signaling that they would not be raising the Fed funds rate above zero for at least another two years or at least through 2014. So, I think with that announcement out there, that made investors feel even more comfortable leaving money market funds, perhaps, and taking on a bit more duration risk. It's interesting, last month you saw over $30 billion in outflows out of money market funds and that total, those outflows, were just about exactly soaked up by what you saw going into taxable and municipal bond funds.

Benz: Now, Kevin, you mentioned the Federal Reserve's stated policy or their intention of keeping short-term interest rates low through 2014, and you conjectured that maybe that has given investors a little more comfort in being in bond funds, maybe they feel like, "Well, I might as well take the duration risk, because it doesn't appear to be a particularly risky move right now." Do you think that there are some pitfalls in that thinking, things that could go wrong for investors who are embracing bond funds at this juncture?

McDevitt: Sure. I think, investors want to be careful about taking too much comfort in the Fed's control over the bond market or how much influence the Fed has over the bond market. Certainly, they play a huge role, and having rates at zero has a big effect on where bond fund yields are, but keep in mind, too, that when the Fed announced QE2 in the fourth quarter of 2010, you actually saw yields rise, you saw Treasury yields rise in the fourth quarter of that year. So, there isn't always that direct correlation or that direct relationship there.

Plus, you've already had yields fall a tremendous amount. In April of 2011, the 10-year Treasury rate was at about 4%. It's now at 2%. It's been cut in half in less than 18 months. So really, it's hard to see where you're going to get that much of a boost on the bond fund side in terms of returns from falling yields.

Then again, certainly inflation risk is always there. If inflation were to kick up; if you had perhaps stronger economic growth than is expected right now, or you saw another surge in commodity prices, all those things could play a role in potentially pushing up rates--pushing up yields, I should say.

Benz: Now I would like to switch gears, Kevin, and talk about what you're seeing in terms of equity fund flows, or more precisely, outflows. The categories there have been seeing pretty big outflows for a while now. Which categories have been hit the hardest?

McDevitt: It's the same old story, Christine. You've seen it really with the growth funds on the domestic side: Large growth and mid-growth and even small growth to some extent, but large growth again had outflows of more than $2 billion, mid-growth funds had outflows of about $1 billion. So, even though growth funds have not performed that much more poorly than the rest of the market in 2011 and in recent years, you still, for some reason, have seen the greatest outflows out of those categories.

Benz: One trend that I've been keeping an eye on, Kevin, is the seeming mania among investors for dividend yield, and I'm wondering if you're seeing that show up in terms of where the flows have been going in the equity fund space?

McDevitt: To the extent that you are seeing flows into equity funds, a lot of them are going into dividend-oriented funds, and the old equity- income objective. That objective has seen--it's not necessarily a category--but that objective has seen very strong flows over the past year, and a lot of those flows have gone into, again, dividend-focused funds and also into index funds which tend to have higher yields, tend to be focused more on larger-cap stocks.

Benz: Kevin, I'd like to also take a look at the fund family level. It's always interesting to see who has been gathering assets and who has been losing assets. Let's talk about the firms first that have been the biggest beneficiaries of new investor dollars recently?

McDevitt: Well, Vanguard again had a very, very strong month, really much stronger than any of its peers. It took in, by our estimates, more than $13 billion in January alone, and that was spread across its most popular index funds, its Total Bond Funds, Total International Stock, and its Institutional Index Fund, which mirrors the S&P 500--all those funds saw very strong inflows.

You also saw DoubleLine Total Return continue to take in strong flows. That fund took in about $2 billion in January alone.

Benz: And you mentioned that Bill Gross seems to have stabilized things on the big Total Return Fund as well at PIMCO?

McDevitt: Right. The Total Return did have positive inflows last month--nothing substantial, nothing really to write home about. In fact, two other funds within the PIMCO lineup had stronger flows than Total Return did--both the high yield fund, PIMCO High Yield, and PIMCO Emerging Markets Bond, both had stronger inflows than Total Return. But yes, Total Return did return to the positive side of the ledger last month.

Benz: Another firm, Kevin, that you noted has seen large inflows recently is also known for its passively managed products, that's DFA, Dimensional Fund Advisors. What products there are seeing asset growth?

McDevitt: They've been in one of the sweet spots, one of the few sweet spots in the equity side, ... Three of their emerging-markets funds have all had very strong inflows in January, but really over the last couple of years, because of the strong returns we've seen out of emerging markets in the last decade or so.

And also too--we've talked about this before, Christine--but there is such a strong narrative, there's such a strong pull for investors, I think, when it comes to investing in emerging markets, despite the fact that 2011 wasn’t an especially strong year for emerging-market equity funds.

Benz: I think that's kind of a head-scratcher. When you look at all this data, it's easy to see how returns are playing a role, but as you indicated, Kevin, 2011 really was a notably poor year for emerging markets, yet the flows there continued to be relatively robust.

McDevitt: Right. I believe the average emerging-markets equity fund lost about 20% in 2011. Now granted those funds bounced back a bit in January; they had positive returns of about 12.5%. So, returns ... bounced back to some extent for these funds in January. But the same could be said domestically, too, and we saw outflows there. So, I think, it just speaks to the fact that emerging-market equity funds still have very strong trailing returns.

If you look over the last decade, the average emerging-market equity fund has gained about 13.5%, which is about 10 percentage points more than the S&P 500 over that time. So, again, those trailing returns are still very strong, plus you just have the narrative of very strong growth, perhaps, in some ways, more promise coming out of those economies. So, I think, that's behind what's driving investor behavior to a great extent.

Benz: Right. So Dimensional, Vanguard, DoubleLine, all big winners. How about the other side of the spectrum, the firms that have been seeing big outflows recently?

McDevitt: Well, it's still, unfortunately for the American Funds, it's the American Funds standing alone there. They continue to have the worse luck, I think, of any fund family. They had about $5 billion or so in outflows last month, led yet again by Growth Fund of America, which had about $3.5 billion in estimated outflows. And it's really astonishing; over the last three years, American now, I believe, they had outflows in 33 of the past 36 months, and they have had outflows in 31 consecutive months. ... There hasn't been any one month in which there has been just a blowout ... there haven't been mass redemptions, net redemptions, in any one month, but it's been a very steady bloodletting for the American Funds. It's hard to see how that's going to change anytime soon.

Benz: But, you know, it's funny Kevin, when you look at performance, certainly category-by-category, you stack up the firm's funds to their peers, there have been some very good performers in the mix. So what do you think has been driving the investor pessimism about the firm?

McDevitt: Well, first of all, you're right. There have been some funds that have performed quite well, especially in 2011. Funds like Washington Mutual did well. New World, their emerging-markets equity fund, on a relative basis at least, had a decent year in 2011.

I think you have seen, though, outside of those funds, there has been some mediocre performance. Again, Growth Fund of America is an example of that. There have been some other prominent funds within the lineup which have struggled a bit. But more to your point, you are right. None of the funds, or I should say, few funds have had truly poor performance.

I think it's, again, maybe a case of investor expectations perhaps still being a bit out of line--what was expected from American Funds versus what they've been able to deliver in recent years. And also to some extent, too, I think, American is perhaps just mirroring what we're seeing demographically, what we're seeing across the board in terms of investors leaving U.S. equity funds, and American's lineup still tends to be dominated by domestic equity-oriented funds.

Benz: They're not a go-to destination for fixed income in the way that, say, a PIMCO is?

McDevitt: Exactly. So to some extent, it's just a matter of investor preferences, too, I think.

ETF and open - end asset flows combined show a strong preference forbonds , emergingmarkets , and passive funds, while active U.S. stockfund managers and money market funds have suffered the brunt of outflows.

Now that the Fed has slowed raising interest rates, it may be time to increase your bondfund holdings. You may also want to consider inching your way out from short-term bonds to intermediate-term bonds . So let's go through a little refresher course of what you need to know as you venture into the ...